ESOP Valuation 101 – Beginners Guide

Employers most often provide employee stock option programs (ESOP) to recruit, retain, and reward talent, increase employee participation, and distribute profits. However, the employee stock ownership plan (ESOP) approach revolves around valuation. When a business first considers an ESOP, its fair market value can influence the plan’s viability, architecture, and funding. Additionally, once a plan is in place, the price of an individual’s allotted shares is determined by yearly valuations. The ESOP valuation is required for reporting Compensation Expenses by a business and for perquisite tax paying. In this article, we will understand the Importance of ESOP valuation, ESOP valuation methods, and ESOP valuation for private companies.

ESOP valuation and private companies

ESOP valuation is necessary for all companies as the plan for issuing stock ownership to the individuals in the business. Valuation of an ESOP is necessary for tax and accounting purposes since it is used to determine the amount of perquisite tax that will be owed by the employees of the firm issuing the ESOP over the vesting period. However, ESOP valuation can be a bit trickier for private, unlisted companies as opposed to publicly listed firms. We’ll discuss that further in the article.

Understand ESOP

ESOP or Employee Stock Ownership Plan is one of the employee benefits businesses can offer that are governed by US law and federally approved. Future share allocations are given to workers through stock options. It is the right, but not the obligation, to purchase a certain number of shares of a corporation at a specified price for a specific length of time. Over 25 additional laws have been passed since 1974, when some of the original ESOP legislation was developed, to promote and enhance its benefits.

Importance of ESOP in private companies

ESOP Schemes provide several benefits to the private company. Especially when their employee compensation is tight. ESOP can allow a competitive edge to private companies over their competitors when hiring with the following benefits:

• Attract employees who can be potential assets to the organization.
• Minimizing attrition by providing additional rewards.
• Liberty to channel funds into other priorities.
• Steer employees toward the organization’s vision,
• Increasing employee retention.
• Derives unparalleled Employee Loyalty.

What is ESOP valuation?

Valuation is a method to find the worth of an asset. Therefore, ESOP valuation is a method of determining the worth of stock options issued to employees through ESOP. The effectiveness of any ESOP plan is greatly influenced by the ESOP valuation, which is used for both the accounting of compensation expenditure by the firm and for the perquisite tax due by the employee.

Why do companies need ESOP valuation?

Companies need ESOP valuation for accounting purposes and tax purposes. The firm issuing the ESOPs must record the compensation costs during the vesting period. Additionally ESOP valuations help determine the perquisite tax due by the company’s personnel. The increased compensation expenditure lowers the company’s earnings per share (EPS), and excess taxes requirements make the ESOP plan undesirable. Therefore, it is necessary to plan ESOP well, and ESOP valuation is crucial in this context.

Key players in ESOP valuation

The Employee Retirement Income Security Act (ERISA) of 1974 regulates employee stock ownership plans. With this regulatory background in mind, it’s important to know who is involved in the ESOP valuation.

• Independent appraiser – This expert, hired by the ESOP trustee, aids in determining the fair market value of the plan sponsor and the share price for ESOP-owned stock. The corporation or its stockholders cannot exert any influence over the appraiser. The independent appraiser’s advice ultimately informs the trustee’s decision about value.
• ESOP trustee – A trustee, who serves as the chief representation of employee trust, oversees all plan participants as the shareholder of record and has a fiduciary duty to them. As a consequence, they are responsible for any share pricing-related claims made against an ESOP. Trustees oversee the execution of an ESOP plan document while consulting with the plan sponsors’ legal and financial experts.
• US department of labor – In compliance with ERISA, the Department of Labor (DOL) oversees all ESOPs on a federal level. The agency checks that the ESOP sale and subsequent appraisals accurately represent fair market value in addition to regulating plan operations and examining the actions of plan specialists.

How does ESOP valuation work?

An independent valuation is required to implement ESOP. When a company sells its stock to an employee trust through an ESOP, the trustee hires an independent and unbiased valuator to determine the fair market value (FMV). The ultimate selling price will be negotiated by the ESOP trustee and plan sponsor using that ESOP valuation.

• Understand first why determining FMV is important – Determining FMV is important in the field of taxation. For example, for real estate donations to nonprofits, donors get tax credits for their gift’s value. Tax authorities must confirm the credit offered is for the donated object’s FMV and typically ask contributors for independent valuations. Correctly applying fair market value to taxes prevents future financial issues or fraud charges. FMV is also required when assets are passed on through transfer or sale. Say, for example, a retiree sells his firm shares to his children for $0.5 so that they can continue running it. However, the cost is well below FMV. The IRS may reclassify transactions for tax reasons. They can ask the entity to pay taxes on the assets as if they were transferred to a third party at FMV.
• Calculate FMV of ESOP – There are a few typical ways to calculate FMV. When a company sells shares to an employee trust via an ESOP, the trustee hires an independent valuator to determine the company’s fair market value (FMV). The valuation is used to negotiate the ultimate selling price. The company issues new shares to employee trust and is compensated per FMV. After the issuance, an independent appraisal determines the corporate income tax benefit. Once an ESOP is created, an impartial valuator will evaluate the plan sponsor annually. This evaluation determines the value of employee shares. The Company buys back its vested shares when employees retire or leave.

How does 409a valuation help find FMV for ESOP?

The regulations that must be adhered to and the requirements that must be fulfilled for creating an ESOP are set out in Section 409A before shares or options may be issued. It was put into place as a response to the massive price manipulations big businesses engaged in throughout the 1990s and the early part of the past decade. These businesses often abused the earlier strategy of internal value setting. The primary goal of the 409A valuation is to guarantee that sufficient federal income taxes are paid on deferred compensation plans, but it also guarantees that stock options are covered by the IRS safe harbor.

• Discounted Cash Flow (DCF) – A DCF uses a company’s estimated future cash flows. The methodology employs a discount rate or the weighted average cost of capital to present value risk-adjusted cash flows. A DCF valuation incorporates hypotheses about a company’s future performance, tax rate, debt-to-equity ratio, and market.
• Public market comparables – This strategy uses public firms’ financial data and expert coverage to evaluate related companies. Public market values aren’t always appropriate to private enterprises owing to size, diversity, and complexity differences.
• Percentage transactions – This strategy values a firm based on recent, industry-specific Mergers and acquisitions. Comparing company-to-company transaction prices has limits. Private company transaction data isn’t always made public.

ESOP valuation methods

ESOP valuation is done either for accounting purposes or tax purposes. Let us look at some commonly used valuation methods in this process-

• Accounting valuation – Accounting valuation is needed to determine employee compensation costs at the time of ESOP issuance, which is then allocated during the vesting period. It is done with the Intrinsic value method & Fair value method.
• Intrinsic valuation methods – Intrinsic Value is the difference between the market price and the price of exercising the option with any upfront payment. If a corporation provides an ESOP with a $100 CMP to its employees, and the shares may be exercised after 2 years for $60, the intrinsic value is $40. (100 – 60).
• Fair value method – The Black-Scholes model is favored for valuing ESOPs since it considers the value of Time, Interest Rate, Variability, Dividend growth, etc. These elements aren’t addressed in intrinsic value, which could underestimate Employee Compensation Cost. Black Scholes’s model evaluates external variables that impact ESOP value, whereas the intrinsic value technique just considers internal components. To compute ESOP options using Black Scholes, consider:
  • Option’s lifespan
  • Cost-benefit analysis
  • Share valuation
  • Share price volatility
  • Dividend expected
  • Risk-free rate

Issues with ESOP valuation

Here are some of the common issues with the Black-Scholes model in ESOP valuation.

• Life of the option – For valuations, we must examine the option’s probable life, not its overall life. For predicted life, average the maximum and minimal option lives for each grant vesting.
• The volatility of united companies – For unlisted/private enterprises, volatility is not available to make accurate valuations. Using zero as the volatility due to the lack of market price for unlisted companies results in incorrect ESOP valuation. The share price of similar listed comparable firms could be used to estimate the unlisted company’s projected volatility.
• Dividend yield – Dividends lower share prices. ESOP holders don’t accumulate dividends throughout the ESOP term. Dividends provided before the ESOP exercise can lower ESOP value. Therefore, companies must establish a dividend yield rate. Historical dividend payout could be used to anticipate future dividend yield.
• Risk-free interest rate – For the calculation, the risk-free rate is the interest rate for a maturity equal to the expected life of the options, based on the zero-coupon yield curve for Government Securities or 10-year government bonds.

How does valuation due diligence work?

During the valuation processes, businesses receive certain requests for the due diligence process. This process includes, most of the time, a conversation of clarity between the appraiser, trustee, and company undergoing valuation with several requisites to conclude valuation. The whole procedure, starting with the initial requests to the conclusion of the valuation process, can take a month or more. Here are some common due diligence requests made to the business:

• Five-year forecasts and related operational information
• Mergers & Acquisition offers pending
• Audited or reviewed financial statements from the past
• Internal financial statements for the whole year
• Recent valuation reports provided by a third party

For initial ESOP transactions and continuing plan operations, business valuation is essential. The value of a plan’s total capital will be included in a sponsor’s IRS Form 5500 filing. Even if complete ESOP values are not publicly disclosed, they are subject to DOL inspection.

How to get an ESOP valuation report from Eqvista?

Work with seasoned fiduciaries and valuation specialists whether you’re an employee-owned business or thinking about issuing ESOPs. Determinations of fair market value are crucial and the subject of examination. An employee stock ownership plan could be extremely successful, provided it has reliable, independent partners.

Executive equity and ESOPs have become more popular as more businesses use them as a retention strategy. Eqvista provides one of the top 409A valuation services in the country, along with fully customizable reports and assistance for all our clients. We can help you make sure the regulations and the requirements in section 409A are fulfilled for creating an ESOP. Additionally, our company valuation experts can also provide a valuation for employee stock option plans (ESOP) and Executive Equity Advisory when the options are granted.

Why choose Eqvista as your ESOP valuation provider?

At Eqvista, we will streamline the ESOP valuation process for you and make it easier for your business. With our highly trained valuation team, we provide one of the best business valuations in the market. Our team guarantees quality valuations and customer support to meet your business needs. To learn more about our different business valuation services, please contact us today!